Stablemania, Part II
Crypto is hard to grasp because it introduces a new tool, called a token, to aid in the determination of value of any goods or service that we’ve never had before.
Say you took up baking bread and you want to sell your freshly baked loaves as a side hustle. How would you set the price of your bread so that you know it would be a good deal for people? You’d probably take a walk down to your local supermarket and note the prices of commercially produced bread, and since it’s homemade, you figure your customers will be delighted to pay a bit of a homemade tax on top. All this work you did to determine the price at which others would buy your loaf is done automatically with the introduction of tokens and decentralized applications that enable people to interact with those tokens. There are mixed feelings around these tokens because we’re just starting to see the extent to which people can assign value to intangible goods such as clout, attention, and community. The price of an asset tied to a token, intangible or otherwise, rests on the delicate balance of supply and demand.
If this brings back the haunted memories of first year econ class for you, you’re on the right track. Spend a few days in crypto and you’ll find that many early crypto adopters moonlight as armchair economists and game theory. After all, what are you to do if you’re looking to launch a new token tied to your loaf of bread and you want people to value it so that it was worth your time and resources? You call an economist who will tell you that to move the demand curve, you’ll need to introduce an incentive.
There are lots of crypto applications where the correct incentive structure to implement is quite obvious. For store of value tokens (tokens whose main purpose is to be a store of value, lol), you might want to consider minting a limited amount to incentivize people purchasing on the belief that the item is rare and coveted. Rarity is likely the only reason Bitcoin will survive forever as a store of value. Another way to incentivize is to provide tangible value: Perhaps in a crypto-based game, a certain item makes the game easier to win at and therefore is worth more.
Designing a compelling incentive structure for people to start using a decentralized stablecoin is not so cut and dry, which really adds an element of drama to these protocols. Consider the following constraints:
Anybody needs to be able to create the token in a trustless manner, which means they are not rare
The value of buying into a new stablecoin protocol is intangible- It comes from the belief that many others will use it as a currency in the future
People need to destroy the token to maintain a stable value if there are too many in circulation, meaning that they literally have to destroy something that should have value
How are you supposed to design a trustless, fully collateralized stablecoin without the obvious incentive structures at your disposal? In this second and final instalment of stablemania, I’ll cover how 2 unpegged and wildly different stablecoin protocols have built enough trust to garner millions of dollars in their reserves.
Starting off simple: RAI
RAI rhymes with DAI (which I covered in my last stablecoin post) because it actually is a fork of DAI- A fork meaning that a bunch of people took the code of DAI and changed it to start something new with the same underlying elements. The defining factor of RAI is that it is unpegged to USD- It has a floating peg rate that will ideally be determined by a governing DAO in the future. Otherwise, it performs exactly the same way: You deposit $1.45 worth of ETH (It has a minimum collateralization ratio of 145% to offset the risk of Ether as an investment) and you borrow $1 worth of RAI in return, which is the minting protocol of RAI. You can return your RAI to the treasury at any time to unlock the same amount of Ether you deposited, which may have appreciated in value in the meantime. When you return your RAI, it is burned.
Incentive to mint RAI
Why would someone deposit $1.45 to receive $1 in return? Well, the idea is that if you outright exchange your $1.45 of Ether to receive $1.45 USD, you are not going to be able to capitalize on gains of Ether if it increases in value in the time you are using USD to pay for something. It basically allows you to capitalize on the gains of Ethereum while productively using the cash for something else. It’s for this reason that minting RAI is also known as “borrowing” it.
You can take the leverage a step further. Say you wanted to doubly capitalize on the gains of Ethereum as it was increasing in value. Like a trader who would borrow money and trade on leverage, you can take your borrowed RAI and use it to purchase even more Ethereum. You effectively took $1.45 and used RAI to turn it into $2.45 worth of token by “borrowing” RAI. If Ethereum increases in value, you would’ve made close to double the returns paying a nearly negligible interest rate for your loan. And that’s really it. RAI banks on people’s need for leverage to incentivize coin minting.
Incentive to destroy RAI
Some people might return their RAI when they’re ready to withdraw their Ether to use it for something else, but the amount of people returning their RAI for burning here and there is not reliable enough to keep the price of RAI in check, especially when there is a lot of hype around the stablecoin protocol. If there are too many coins minted (supply increases), the price of the so-called “stable” coin is going to decrease.
To incentivize burning, the RAI protocol has set a separate “redemption price” that is separate from RAI’s market price. The redemption price is what the protocol says a RAI token is worth to the protocol, and the goal is to have the redemption price be as close as possible to the market price. If they’re different, users are incentivized to either create or return their tokens.
Currently, the redemption price of 1 RAI is about $5.20 while the market price is about $3.02. What if I’m an investor that has minted some RAI from the protocol in the past? Say I paid about $8 in ether to receive 1 RAI at the $5.20 price and I used it somewhere else. Now, I can buy another single RAI token from the market at $3.02 and use it to get my entire $8 ether deposit back. Put simply, if the redemption price of RAI is higher than the market place, investors have an incentive to buy back RAI for cheaper from the market and return their RAI to be burned. The hope is that this will reliably decrease circulation until the redemption price is the same as the market price, and RAI remains stable.
Now, the real Beautiful Minds shit: OHM
OlympusDAO was founded by a peculiar pseudonymous duo: One, a veteran crypto software developer, and the other, a game theory nerd. The pair plotted an entire stablecoin protocol on a good old game theory matrix.
In game theory, a Nash equilibrium occurs when when every decision maker has selected the decision in which they do best no matter what the other player decides to play. This table illustrates (perhaps optimistically) that the best decision to make regardless of what the other player decides is to stake: Even if the other player sells, you’re left with a payout of 1. Since it’s the best decision for one player regardless of how others act, you can be convinced that most people in this trustless system will also decide to stake as well. This has been such a successful concept in developing cooperation that currently about $4 Billion dollars have been staked in OlympusDAO’s protocol.
Let’s go through what each of these actions mean:
Staking: Users stake their OHM by locking up any OHM they’ve acquired through bonding or buying it on the market, and this creates liquidity in the OHM ecosystem for OlympusDAO to use in liquidity pools for lending, or to pay back OHM bonds. Users are incentivized to stake earlier on when there are fewer OHM in circulation because future gains are determined based on how much OHM each person owns (eg. if you own 2% of OHM staked, then you get 2% of new OHM tokens minted). About 90% of OHM is staked right now.
Bonding: Users buy bonds in OlympusDAO just like you would buy government bonds: You give them a certain amount of money, and they allow you to earn it all back with interest at a later date in the form of OHM at a discounted price from the market. OlympusDAO takes the money from bonds and uses it as reserve assets to mint more OHM- Each OHM is backed by 1 DAI. Any new OHM that is minted is provided to stakers first proportional to how much OHM they’ve staked.
Selling: Selling is when you remove your stake (unstake), and therefore your liquidity, from OHM and you sell it on the market in exchange for another asset instead. Flooding the market with OHM lowers its value, selling is necessary to balance out the value of OHM when staking becomes so diluted there is no benefit to doing it in the future. At that stage, the coins in circulation will theoretically reach “stable” currency territory and can be adopted for everyday use.
Takeaways
Maybe this won’t come as a surprise because it seems obvious: The incentive mechanisms designed to get stablecoin protocols off the ground have optimized for upfront returns to their investors. OHM especially rewards its earliest adopters more than future ones, which it needs to do because it is riskier. It remains unclear if the price of OHM will ever reach its theoretical stable point. RAI follows DAI’s tried and true model for leverage, but hinges a bullish market sentiment for its underlying assets to function and doesn’t provide the same to-good-to-be-true astronomical returns.
These incentive structures to bring people into online communities are still nascent, which is both terrifying and fascinating. If anything, crypto tokens are going to push our studies of economics and value to new heights, and I’m optimistic we’ll finally find a way to value important yet unproductive intangibles like compassion, happiness, and freedom.